Should you use a Traditional IRA or Roth IRA for retirement savings? (Episode007)

Podcast Episode Overview

In this episode, I answer a listener question about how to save for retirement. Specifically, “Should I be using a traditional IRA, Roth IRA, or both for retirement saving?”

In order to answer this question, I provide a general overview of the features for both a Traditional and Roth IRA. When you have the option between a Traditional IRA or a Roth IRA it is important to understand the similarities and differences. I break down the pros and cons for each of these tax-advantaged accounts. Finally, I provide some rules of thumb which you can choose to make a decision on which type of IRA best fits your situation.

Overview of a Roth IRA

Don’t pay any taxes on capital gains, dividends, or interest while in the account. (Tax deferral)

No taxes owed when withdrawn in retirement.

Contributions are restricted in part or whole once your income exceeds a certain limit. ($120,000 single or HOH, and $189,000 married filing jointly)

Key Similarities between a Traditional IRA and Roth IRA

The contribution limit is the same at $5,500 or $6,500 if over 50 years old

Both accounts provide tax deferral

Both involve a tax penalty for withdrawals of earnings under the age of 59 and a half.

Key Differences between a Traditional IRA and Roth IRA

Tax Deductible (Trad) or Tax Exempt (Roth)

No required minimum distributions for the Roth IRA

Which is better? It all comes down to your assumptions

Current Income / Tax Rate

High current income prefers traditional IRA

Low current income prefers Roth IRA

Retirement Income / Tax Rate

High retirement income prefers Roth IRA

Low retirement income prefers Traditional IRA

Will income taxes go up over time, stay the same, or be reduced?

This is the absolutely most important thing to consider. Many people when doing this analysis simply assume that Tax Rates will remain constant. This is a BAD assumptions. Tax rates change all the time.

Government debt is increasing, and at some point tax rates will have to rise.

Now, it might not be INCOME TAX rates that rise. A national sales tax or VAT is also a possible way of raising income.

The answer: Should you use a traditional IRA or a Roth IRA or both for retirement saving?

Short answer: It depends

Long answer: I’ll dive into some rules of thumb which should help, and some general thoughts on how I think about it.

Rules of Thumb:

If you make less than the standard deduction (12k singles, 24k married) you’re in the 0% tax bracket. This is an obvious choice. You should save in a Roth IRA.

The same is also true for the 10% and 12% tax brackets.

Basically, if you make up to $50,700 single or up to $101,400 married in gross income, you should be contributing ONLY to a Roth IRA.

Your goal SHOULD be to build enough wealth that you would otherwise be in a higher tax bracket when you retire. You also have the added benefit of not having to make required minimum distributions.

What about as you get higher in income? At some point, it might make sense to use a traditional IRA. However, that’s only true if you fall into a specific category. Something along the lines of early retirement or financial independence mindset. Where you make a lot of money now and live on a very small amount. Therefore, when you retire you can retire on a lower income than you earn now.

If that’s the case, you should absolutely be using a traditional IRA. because you’ll pay no taxes when the money goes in, and little to no taxes when you withdraw the money.

Should you use both? NO.

It’s pretty simple. There is a right and a wrong answer depending on where you are in the income stream and your plans. Doing both just means you don’t understand your retirement goals.

My default: Roth IRA.

Tax Exempt is better than tax deductible. I also intend to save a lot of money and become wealthy in retirement. If I’m successful, I will retire at a much higher tax bracket than I’m working at. This is mainly driven by time and compounding. I want to protect all of my money from future taxes if I can.

But also, I don’t want to be subject to required minimum distributions.

About Trey Henninger

Trey is a private investment portfolio manager for his own personal funds. He began investing in 2011 and has over 7 years of experience managing an investment portfolio as well as performing fundamental stock and business analysis. Trey has been writing about his investing research, investing theory, and personal finance since 2015. He used thousands of hours of reading and learning to teach himself to invest and hopes to help other like-minded investors become DIY investors as well.

Trey graduated from the University of Texas with a Bachelor of Science degree in Chemical Engineering with a concentration in Engineering Economics and Business Leadership. He leverages this background in engineering economics to better identify and understand capital intensive and capital-light businesses. He has been quoted on Nerd Wallet, InvestorPlace, GoBankingRates and other online publications.

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